Federal Reserve Bank of Minneapolis Research Department Staff Report 377 Revised: April 2014 (First version: September 2006) Demographics in Dynamic Heckscher-Ohlin Models: Overlapping Generations versus Infinitely Lived Consumers*

Claustre Bajona

Ryerson University

Timothy J. Kehoe

University of Minnesota, Federal Reserve Bank of Minneapolis, and National Bureau of Economic Research

ABSTRACT ___________________________________________________________________________

We contrast the properties of dynamic Heckscher-Ohlin models with overlapping generations with those of models with infinitely lived consumers under both closed and open international capital markets. In both environments, if capital is mobile, factor price equalization occurs after the initial period. If capital is not mobile, the properties of equilibria differ drastically across environments: With infinitely lived consumers, factor prices equalize in any steady state or cycle and, in general, there is positive trade in any steady state or cycle. With overlapping generations, we construct examples with steady states and cycles in which factor prices are not equalized, and any equilibrium that converges to a steady state or a cycle with factor price equalization has no trade after a finite number of periods.

Keywords: International trade; Factor price equalization; Equilibrium cycle; Chaos JEL classification: C61, F11, O41 _____________________________________________________________________________________ * A preliminary version of this paper with the title “On Dynamic Heckscher-Ohlin Models I: General Framework and Overlapping Generations” was circulated in January 2003. Kehoe thanks the National Science Foundation for support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

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1. Introduction

Traditional Heckscher-Ohlin models are static and are designed to capture changes in the

reallocation of resources across sectors that happen within a country when it opens to trade.

Opening to international trade has other effects that are dynamic in nature. In particular, opening

may alter the pattern of capital accumulation in a country and, thus, have effects on the country’s

growth and development path. As economists have become more interested in the dynamic aspects

of international trade, the need for models that introduce trade in a dynamic framework has arisen.

One of the early options chosen in the literature was to combine a Heckscher-Ohlin model of trade

with two-sector growth models. Starting with the work of Oniki and Uzawa (1965), Bardhan

(1965), and Stiglitz (1970), different versions of these models, with different (and sometimes

contradictory) simplifying assumptions, have been used in the literature. For instance, Oniki and

Uzawa (1965) assume that countries differ in either their savings rates or their rates of time

preference, which implies that factor prices are not equalized in the long run. In contrast, Chen

(1992) develops his analysis under the assumption that factor prices do equalize in the long run.

Dynamic Heckscher-Ohlin models have also been constructed using an overlapping generations

framework. In this area, the models and assumptions are even more variable: Bianconi (1995)

assumes differences in tax rates across countries; Galor and Lin (1997) assume that countries differ

in their rates of time preference; and Sayan (2005) assumes differences in population growth rates,

just to cite a few. In view of this diversity of assumptions and frameworks, there is the need for a

unified environment (departing as little as possible from the fundamental Heckscher-Ohlin

assumptions) that allows us to determine the equilibrium properties of dynamic Heckscher-Ohlin

models.

In this paper, we present such a unified framework. We study the properties of dynamic

Heckscher-Ohlin models with two different demographic environments: an infinitely lived

consumer environment and an overlapping generations environment. In our dynamic Heckscher-

Ohlin model, a finite number of countries that differ only in population sizes and initial

endowments of capital (as in the traditional Heckscher-Ohlin model) interact with each other by

exchanging two traded goods, which are produced using capital and labor. The traded goods are

used either in consumption or in the production of a nontraded investment good. Consumers

supply labor inelastically and choose levels of consumption and capital accumulation to maximize

their lifetime utility.

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We find that the equilibrium properties of the model depend crucially on the assumptions

made on international capital markets and on the choice of demographic environment. If

international borrowing and lending are permitted, factor prices equalize after the first period,

independently of the environment. Furthermore, the levels of capital and of international

borrowing are not determined in equilibrium. At any given point in the equilibrium path, there is a

continuum of possible continuation paths that have all the same prices and aggregate variables, but

differ in the distribution of capital and international borrowing across countries and in the pattern

of production and trade.

If international borrowing and lending are not permitted, then the equilibrium properties

vary depending on the demographic environment. In the infinitely lived consumer environment, if

a nontrivial steady state exists, then there is a continuum of nontrivial steady states, indexed by the

distribution of capital across countries. To which steady state the world economy converges

depends on initial endowments of capital. Factor prices equalize in all steady states, and trade is

positive in all steady states except the one where initial capital-labor ratios are equal across

countries. In the overlapping generations environment, any nontrivial steady state with factor price

equalization is autarkic and has no trade. Furthermore, we show using examples that factor price

equalization does not need to occur in steady state. Therefore, the factor price equalization

assumption is innocuous in long-run analyses of the model under the infinitely lived consumer

framework, but not under the overlapping generations framework. Both environments also differ

in the behavior of equilibrium paths that converge to a steady state. In the overlapping generations

environment, any equilibrium converging to a steady state where factor prices equalize becomes

autarkic in a finite number of periods. No corresponding result exists for the infinitely lived

consumer environment.

As in two-sector closed economy models, equilibrium paths may exhibit cycles and chaotic

behavior. In the infinitely lived consumer environment, we show that factor prices equalize in any

equilibrium cycle. In the overlapping generations environment, we show using examples that there

may exist equilibrium cycles in which factor prices are not equalized. The paper develops a

methodology for constructing two-country, two-sector, overlapping generations models from

closed one- and two-sector economies in such a way that preserves their properties in terms of

multiplicity of equilibria or cyclical behavior. Therefore, the overlapping generations models can

present the same richness of equilibrium patterns as in closed economy models.

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Our paper also contains an interesting methodological contribution. We develop a

methodology to construct examples of trade economies for the overlapping generations’ framework

starting from one-sector closed economy models. This methodology is quite general and can be

applied to a large number of settings.

The literature on dynamic Heckscher-Ohlin models was pioneered by Oniki and Uzawa

(1965), Bardhan (1965), Stiglitz (1970), and Deardorff and Hanson (1978). In their models,

countries produce two traded goods — a consumption good and an investment good — using

production functions that differ across sectors but not across countries. In addition to differences in

endowments, these papers also assume that countries have different savings rates or rates of time

preference, so that no factor price equalization occurs in steady state. In steady state, factor prices

are not equalized and, thus, the steady state is independent of initial conditions. Our model differs

from theirs in two crucial aspects: we consider utility-maximizing consumers, and we do not

impose any modeling assumptions restricting the equilibrium behavior of factor prices. Baxter

(1992) studies the long-run behavior of a dynamic Heckscher-Ohlin model where countries differ

in tax policy and shows how changes in tax policy may lead to reversals in comparative advantage.

Cuñat and Maffezzoli (2004a) calibrate a specific dynamic trade model and study issues of

convergence in income levels across countries under the assumption that factor prices do not

equalize over time.

In contrast to the early literature, more recent papers impose, by assumption or by the

choice of production functions, factor price equalization along the equilibrium path. Cuñat and

Maffezzoli (2004b) introduce technology shocks and study the business cycle properties of a

dynamic Heckscher-Ohlin model under the assumption of factor price equalization. Chen (1992)

studies the equilibrium properties of a dynamic Heckscher-Ohlin model with elastic labor supply

under the assumption that factor prices equalize along the equilibrium path. Ventura (1997) adds

additional structure to the model that guarantees that factor prices equalize in equilibrium,

independently of initial conditions, and that rules out the possibility of cyclical and chaotic

behavior. He derives results regarding convergence of income distribution across countries over

time. Bajona and Kehoe (2010) study the properties of a generalized version of Ventura’s model

without imposing factor price equalization. They show that the convergence results of Ventura

(1997) depend crucially on the factor price equalization assumption.

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A related literature considers two-sector growth models with infinitely lived consumers

under the small open economy assumption. In the infinitely lived consumer environment, these

papers include Findlay (1970), Mussa (1978), Smith (1984), Atkeson and Kehoe (2000), Chatterjee

and Shukayev (2006), and Obiols-Homs (2005).

The literature on dynamic Heckscher-Ohlin models in an overlapping generations

environment is less abundant. Galor (1992) characterizes the dynamics of a two-sector, two-

period-lived overlapping generations model of growth in a closed economy. Papers using two-

country versions of Galor (1992) assume some difference across countries besides factor

endowments, usually without justifying the reason for their choice. For example, Bianconi (1995)

assumes differences in tax rates across countries; Galor and Lin (1997) and Mountford (1998)

assume that countries differ in their rates of time preference; Sayan (2005) assumes differences in

population growth rates. All these papers study the long-run properties of the model under the

factor price equalization assumption. Papers that study the two-sector overlapping generations

environment under the small open economy assumption include Serra (1991), Gokcekus and Tower

(1998), Kemp and Wong (1995), and Fisher (1992).

A recent literature constructs dynamic Heckscher-Ohlin models that exhibit endogenous

growth. In the infinitely lived environment, Nishimura and Shimomura (2002) and Bond, Trask

and Wang (2003) derive some results regarding indeterminacy of equilibria. Guilló (1999) and

Mountford (1999) introduce production externalities in the overlapping generations environment.

2. The model

There are n countries in the model, which differ in their population sizes and their initial

endowments of capital. Each country can produce three goods: two traded goods — a capital

intensive good and a labor intensive good — and a nontraded investment good. The technologies

available to produce these goods are the same across countries. Each traded good j , 1, 2j , is

produced using capital and labor according to the production function ( , )j j j jy k .

A.1. The functions j are increasing, concave, continuously differentiable, and homogeneous of

degree one.

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We assume that j is continuously differentiable to simplify the exposition, and we let additional

subscripts — ( , )jK j jk , ( , )jL j jk — denote partial derivatives. It is an open question whether

any substantive conclusion depends on this assumption. In particular, our analysis is easily

extended to the fixed coefficient production functions, min[ / , / ]j j jK j jLy k a a .

Producers minimize costs taking prices as given and earn zero profits:

( , )j jK j jr p k , with equality if 0jk (1)

( , )j jL j jw p k , with equality if 0j (2)

for 1, 2j . Here r is the rental rate, w is the wage, and 1p and 2p are the prices of the traded

goods.

A.2. Good 1 is relatively capital intensive and there is no capital intensity reversal. That is,

1 2

1 2

( / ,1) ( / ,1)

( / ,1) ( / ,1)L L

K K

k k

k k

for all / 0k . (3)

This condition and the concavity of 1 and 2 imply that for any wage-rental ratio /w r , the profit

maximizing capital-labor ratios satisfy 1 1 2 2k k . Notice that, if the production functions j ,

1, 2j , display constant elasticities of substitution, assumption A.2 implies that both production

functions have the same elasticity of substitution.

The investment good is produced using the two traded goods with production function

1 2( , )x f x x .

A.3. The function f is increasing, concave, continuously differentiable, and homogeneous of

degree one. Capital depreciates at the rate , 1 0 .

The first-order conditions for profit maximization are

1 1 1 2 ( , )p qf x x , with equality if 1 0x (4)

2 2 1 2 ( , )p qf x x , with equality if 2 0x , (5)

where q is the price of the investment good.

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A.4. Labor and capital are not mobile across countries, but are mobile across sectors within a

country.

2.1. Infinitely lived consumers

In the environment with infinitely lived consumers, each country , 1,...,i i n , has a

continuum of measure iL of consumers, each of whom is endowed with 0 0ik units of capital in

period 0 and one unit of labor at every period, which is supplied inelastically. Consumers have the

same utility functions, within countries and across countries. In each period, the representative

consumer in country i decides how much to consume of each of the two traded goods in the

economy, 1itc , 2

itc , how much capital to accumulate for the next period, 1

itk , and how much to lend,

1itb . Consumers derive their income from wages, i

tw , returns to capital, itr , and returns to lending,

bitr . The representative consumer in country i solves the problem

1 20max ( , )t i i

t ttu c c

1 1 2 2 1s.t. (1 )i i i i i i i i bi it t t t t t t t t t t tp c p c q x b w r k r b (6)

1 (1 )i i it t tk k x

0ijtc , 0i

tx , itb B

0 0i ik k , 0 0ib .

Here, B is a positive number large enough so that the constraint itb B rules out Ponzi schemes

but does not otherwise bind in equilibrium.

A.5. The period utility function 1 2( , )u c c is homothetic, strictly increasing, strictly concave, and

continuously differentiable, with 0 1 2lim ( , )jc ju c c , and 1 2lim ( , ) 0

jc ju c c .

The first-order conditions of this consumer’s problem (6) imply that

2 1 2 2

1 1 2 1

( , )

( , )

i it t t

i it t t

u c c p

u c c p (7)

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1 1 2 11 1

1 1 1 2 1 1 1

( , )(1 )

( , )

i ii it t tt ti i i

t t t t

u c c pq r

u c c p q

, with equality if 0itx . (8)

Furthermore, the returns to capital and to international bonds, if borrowing and lending are

permitted, have to be the same:

1 11

(1 )1

i ibi t t

t it

q rr

q

, with equality if 0i

tx . (9)

The feasibility condition for each traded good j , 1, 2j , in period t , 0,1,...t , is

1 1

( )n ni i i i i

jt jt jti iL c x L y

. (10)

Here, ijty and i

jtx denote, respectively, the output and input into investment of traded good j in

country i , both expressed in per worker terms. Notice that, because each consumer is endowed

with one unit of labor in every period, these quantities are also the same quantities per unit of labor.

It is easy to modify the model, as does Ventura (1997), so that the endowment of labor per worker

differs across countries, as long as these differences remain constant over time. The feasibility

conditions for factors and for the investment good are

1 2i i it t tk k k (11)

1 2 1i it t (12)

1 (1 )i i it t tk k x . (13)

The market clearing condition for international bonds is

1

0n i i

tiLb

(14)

when international borrowing and lending are permitted. If not, this condition becomes 0itb .

2.2. Overlapping generations

In the environment with overlapping generations, a new generation of consumers is born in

each period in each country. Consumers in generation t , 0,1,...t , are born in period t and live

for m periods. Each of these generations in country i has a continuum of measure iL of

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consumers. In period of life , 1,...,h h m , each consumer is endowed with h units of labor,

which are supplied inelastically. Consumers can save through accumulation of capital and bonds.

We assume that they are born without any initial endowment of capital or bonds. The

representative consumer born in country i in period t , 0,1,...t , solves

1 1 2 11max ( , )

m it ith h t h t hhu c c

1 1 1 1 2 1 2 1 1 1 1 1 1 1 1s.t. (1 )it it i it it i h i it bi itt h t h t h t h t h t h t h t h t h t h t h t hp c p c q x b w r k r b (15)

1 1(1 )it it itt h t h t hk k x

1 0itjt hc , 1 0it

t hx

0ittk , 0it

tb , 1 1(1 )it itt m t mx k , 0it

t mb ,

where hu is the utility function in period of life h and satisfies the analogue of assumption A.5:

A.5'. For every h , 1,...,h m , the utility function 1 2( , )hu c c is homothetic, strictly increasing,

strictly concave, and continuously differentiable, with 0 1 2lim ( , )jc hju c c and

1 2lim ( , ) 0jc hju c c .

In addition, there are 1m generations of initial old consumers alive in period 0. Each

generation , 1,..., 1s s m , in country i has a continuum of measure iL of consumers, each of

whom lives for m s periods and is endowed with h s units of labor in period h , 1,...,h m s .

Each initial old consumer is also endowed with capital 0isk and bonds 0

isb . The representative

consumer of generation t , 1,..., 1t m , in country i solves

1 1 2 11max ( , )

m it ith h t h t hh tu c c

1 1 1 1 2 1 2 1 1 1 1 1 1 1 1s.t. (1 )it it i it it i h bi it i itt h t h t h t h t h t h t h t h t h t h t h t hp c p c q x b w r b r k (16)

1 1(1 )it it itt h t h t hk k x

1 0itjt hc , 1 0it

ht hx

0 0it itk k , 0 0

it itb b , 1 1(1 )it itt m t mx k , 0it

t mb .

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Notice that in each country i and each period t , the total population is imL and — normalizing the

total supply of labor per period to be 1, 1

1m h

h — the total amount of labor is iL .

The feasibility condition for traded good j , 1, 2j , in period t , 0,1,...t , is

1

1 1 1

n m ni it h i i ijt jt jti h i

L c x L y

. (17)

Notice that, in this notation, ijty and i

jtx are expressed in terms of per unit of labor, not in terms of

per capita. The output per capita of traded good j in country i in period t is /ijty m , for example.

The feasibility conditions for factor inputs and for the investment good are the same as in the

infinitely lived consumer environment and are given by equations (11), (12), and (13).

Given intergenerational heterogeneity, we need to impose additional feasibility conditions

in the overlapping generations environment:

1 1

1

mi it ht th

x x

(18)

1

2

mi it ht th

k k

. (19)

We also need to impose a market clearing condition on bonds. If international borrowing

and lending are permitted, then bi bt tr r and this condition is

1101 2 1 10

(1 )tn m ni it h b i ih

t si h i h msL b r L b

. (20)

If the initial nominal assets satisfy

1

01 10

n i ih

i h mL b

, (21)

then the world has fiat money. If, however,

1

01 10

n i ih

i h mL b

, (22)

then the world does not have fiat money.

If international borrowing and lending are not permitted, then the market clearing condition

on bonds within each country becomes

1102 10

(1 )tm it h bi ih

t sh h msb r b

, 1,...,i n . (23)

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If

1

010ih

h mb

, (24)

then country i has fiat money, and, if

1

010ih

h mb

, (25)

then country i does not have fiat money.

3. Equilibrium

We give unified definitions of equilibrium and of steady states for Heckscher-Ohlin models

with infinitely lived consumers and with overlapping generations.

Definition 1. There are n countries of different sizes, iL , 1,...,i n , and different initial

endowments of capital and bonds: 0ik and 0

ib , 1,...,i n , in the environment with infinitely lived

consumers and 0isk and 0

isb , 1,..., 1s m , 1,...,i n , in the environment with overlapping

generations. An equilibrium is sequences of consumptions, investments, capital stocks, and bond

holdings, 1 2{ , , , , }i i i i it t t t tc c x k b in the environment with infinitely lived consumers and

1 2{ , , , , }is is is is ist t t t tc c x k b , 1,...,s t m t , in the environment with overlapping generations, output and

inputs for each traded industry, { , , }i i ijt jt jty k l , 1, 2j , output and inputs for the investment sector

1 2{ , , }i i it t tx x x , and prices 1 2{ , , , , , }i i i bi

t t t t t tp p q w r r , 1,...,i n , 0,1, 2...t , such that

1. Given prices 1 2{ , , , , , }i i i bit t t t t tp p q w r r , the consumption and accumulation plan 1 2{ , , , , }i i i i i

t t t t tc c x k b

solves the consumers’ problem (6) in the environment with infinitely lived consumers, and the

consumption and accumulation plan 1 2{ , , , , }is is is is ist t t t tc c x k b solves the consumers’ problems (15)

and (16) in the environment with overlapping generations.

2. Given prices 1 2{ , , , , , }i i i bit t t t t tp p q w r r , the production plans { , , }i i i

jt jt jty k l and 1 2{ , , }i i it t tx x x satisfy

the cost minimization and zero profit conditions (1), (2), (4), and (5).

3. The consumption, capital stock, 1 2{ , , , , }i i i i it t t t tc c x k b or 1 2{ , , , , }is is is is is

t t t t tc c x k b , and production plans,

{ , , }i i ijt jt jty k l and 1 2{ , , }i i i

t t tx x x , satisfy (10)–(14) in the infinitely lived consumer environment and

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(17)–(25) in the overlapping generations environment and the feasibility conditions in each

environment.

Definition 2. A steady state is a set of consumption levels, an investment level, a capital stock, and

bond holdings, 1 2ˆ ˆˆ ˆ ˆ( , , , , )i i i i ic c x k b in the environment with infinitely lived consumers and

1 2ˆ ˆˆ ˆ ˆ( , , , , )is is is is isc c x k b , 1,...,s m , in the environment with overlapping generations, output and inputs

for each traded industry, ˆ ˆˆ( , , )i i ij j jy k l , 1, 2j , output and inputs for the investment sector,

1 2ˆ ˆ ˆ( , , )i i ix x x , and prices, 1 2ˆ ˆ ˆ ˆ ˆ ˆ( , , , , , )i i bip p q w r r , 1,...,i n , that satisfy the conditions of a competitive

equilibrium for appropriate initial endowments of capital and bonds, 0ˆi ik k , 0

ˆi ib b in the

environment with infinitely lived consumers and 0ˆis isk k and 0

ˆis isb b in the environment with

overlapping generations. Here we set ˆt for all t , where represents a generic variable.

Definition 3. An equilibrium displays sustainable growth if there exists a constant 1 such

that 1 1liminf / liminf /i i i it t t t t tk k c c , 1,...,i n .

We often assume in the paper that the initial conditions are such that all countries produce a

positive amount of the investment good in every period, 0itx , and we normalize 1i

t tq q for

all t . We make two remarks regarding this assumption: First, since the investment good is

produced using the two traded goods, and these prices are equalized across countries by trade,

even if a country does not produce the investment good in a given period, the price of the

investment good is the same as in countries that produce the investment good. Second, in the

examples presented in this paper, we assume complete depreciation, 1 , and the assumption of

positive investment becomes an assumption of positive capital, 0i it tx k . Positive capital in all

countries in every period can be ensured by assuming Inada conditions on the production functions

j . Bajona and Kehoe (2010) construct an example with corner solutions in investment and in

capital in a model where production functions do not satisfy Inada conditions. In their example, the

convergence properties of the equilibrium differ from the properties of equilibrium with 0itx

along the whole equilibrium path. In more general cases where 1 , the assumption 0itx is

still restrictive.

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The characterization and computation of equilibrium of the models described above is

difficult in general because it involves determining the pattern of specialization in production over

an infinite horizon. In particular, for any prices of the traded goods, 1tp , 2tp , there exists threshold

values 1 2 1( / )t tp p and 2 2 1( / )t tp p such that a country produces positive amounts of both traded

goods if and only if its capital-labor ratio itk satisfies 1 2 1 2 2 1( / ) ( / )i

t t t t tp p k p p .

The set of capital-labor ratios that satisfy weak versions of these inequalities is called the cone of

diversification. Figure 1, known as the Lerner diagram, depicts the cone of diversification

graphically. Any two countries with endowments in the cone of diversification use capital and

labor in the same proportions and face the same factor prices, tr and tw . If the assumption of no

factor intensity reversal, A.2, is violated, there can be more than one cone of diversification and

more than one pair of factor prices compatible with production of both goods in equilibrium.

If all countries have endowments in the cone of diversification at some prices of the traded

goods, we say that factor price equalization occurs at those prices. This result is the factor price

equalization theorem of static Heckscher-Ohlin theory. Notice that, given the endowments of

capital and labor in each country in each period, the production of traded goods is identical to that

in a static, two-sector Heckscher-Ohlin model. Consequently, the Rybszynski theorem and the

Stolper-Samuelson theorem also hold in our framework.

To prove a version of the Heckscher-Ohlin theorem for this model — that, in any period, a

country exports the good that is intensive in the factor in which it is abundant — we would need to

make assumptions to ensure that trade is balanced for each country and that expenditures on the

two traded goods are proportional across countries. In the next section, we assume that there is no

international borrowing and lending, which ensures that trade is balanced for each country.

Assumption A.3 ensures that 1 2/i it tx x is equal across countries. In the infinitely lived consumer

environment, assumption A.5 ensures that 1 2/i it tc c is equal across countries, but our assumptions do

not impose any restrictions on 1 1 2 2( ) /( )i i i it t t tc x c x . If we assume — as does Ventura (1997) —

that 1 2 1 2( , ) ( ( , ))u c c v f c c , where v is strictly concave and increasing, then we know that

1 2 1 2/ /i i i it t t tc c x x , which implies that 1 1 2 2( ) /( )i i i i

t t t tc x c x is equal across countries and that the

Heckscher-Ohlin theorem holds. Similarly, in the overlapping generations environment, we would

need to strengthen assumption A.5' by assuming that 1 2 1 2( , ) ( ( , ))h hu c c v f c c for all h to be able to

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prove the Heckscher-Ohlin theorem. If we do not make this sort of assumption on the relation

between consumption and investment, there is no reason to expect the Heckscher-Ohlin theorem to

hold. In this case, it is easy to construct examples in which a capital abundant country exports the

labor intensive good.

If factor price equalization occurs in every period, the equilibrium prices and aggregate

variables of the model can be determined by solving for the equilibrium of the integrated economy,

a closed economy with factor endowments equal to the world endowments of the factors of

production. (See Dixit and Norman 1980 for a description of the methodology.) The equilibrium

of the n -country model is then computed by disaggregating the consumption, production, and

investment allocations of the integrated economy across countries in a way that is consistent with

initial conditions. The integrated economy approach greatly simplifies the characterization of

equilibrium in static models. As we will see, it is even more useful in the dynamic models

considered in this paper. The question arises of how general is a situation where factor prices are

equalized along the equilibrium path. The existing literature abstracts away from this question

either by assuming factor price equalization along the equilibrium path — as in Chen (1992),

Ventura (1997), and Cuñat and Maffezzoli (2004a) — or by not allowing for factor prices to

equalize — as in Baxter (1992) and Cuñat and Maffezzoli (2004b). In this paper, we abstract out

from such assumptions and derive general results regarding factor price equalization in long-run

equilibria and along equilibrium paths. In doing so, we shed light on the relationship between the

assumptions made in the model and the results obtained in the literature.

4. General model with international borrowing and lending

When embedding a static trade model into a dynamic framework, the first question that

arises is whether international borrowing and lending should be permitted. Most papers in the

literature do not allow for such capital flows. In this section, we obtain two results for models with

both infinitely lived consumers and overlapping generations when international borrowing and

lending are permitted. The proofs are in appendix 2.

Proposition 1: In both a model with infinitely lived consumers that satisfies A.1–A.5 and a model

with overlapping generations that satisfies assumptions A.1–A.4 and A.5', assume that international

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borrowing and lending are permitted. Also assume that 0itx for all i and all t . Then factor price

equalization occurs for all 1, 2,...t .

Proposition 2: In both a model with infinitely lived consumers that satisfies A.1–A.5 and a model

with overlapping generations that satisfies assumptions A.1–A.4 and A.5', assume that international

borrowing and lending are permitted. Also assume that 0itx for all i and all t . Then countries’

production plans and international trade patterns are not determinate for any period 0t .

The intuition for these propositions is the classic result in static Heckscher-Ohlin theory that

trade in goods is a substitute for factor mobility. (See, for example, Mundell 1957 and Markusen

1983.) The assumption that 0itx for all i and all t is a far stronger assumption than we need to

prove proposition 2, as we explain in the proof of the proposition in the appendix.

In the rest of the paper, we study versions of the general model where international

borrowing and lending are not permitted. Therefore, we add the following assumptions:

A.6. In the infinitely lived consumer environment, assume that 0itb for all 0,1,...t , 1,...,i n .

A.6'. In the overlapping generations environment, assume that

1102 10

(1 )tm it h bi ih

t sh h msb r b

for all 0,1,...t , 1,...,i n .

In addition, in what follows we sometimes assume that consumers aggregate the two traded

goods to obtain utility in the same way that firms aggregate these goods to obtain the investment

good.

Definition 4. A model with infinitely lived consumers that satisfies A.1–A.6 is one-sector

aggregatable if 1 2 1 2( , ) ( ( , ))u c c v f c c for some v that is continuously differentiable, strictly

concave, and strictly increasing. Similarly, a model with overlapping generations that satisfies

A.1–A.4 and A.5'–A.6' is one-sector aggregatable if 1 2 1 2( , ) ( ( , ))h hu c c v f c c for some hv ,

1,...,h m , that satisfy these properties.

15

As we have seen, this assumption — which is very restrictive — guarantees that trade patterns

obey the Heckscher-Ohlin theorem. As we shall see, it is also useful in restricting the possible

dynamic behavior of equilibria.

5. Model economy with infinitely lived consumers

In this section, we study the behavior of equilibrium paths for the model with infinitely

lived consumers. As mentioned in section 3, once the assumption of factor price equalization is

relaxed, the integrated approach cannot be used. Nevertheless, properties of the solution can be

derived if we take into account that equilibrium allocations in each country i solve a country

planner’s problem in a one-sector growth model with a time varying production function, following

an approach similar to that used by Chen (1992). To construct this planner’s problem, we begin by

aggregating consumption of the two traded goods. The homotheticity assumption A.5 implies that

1 2 1 2( , ) ( , )u c c v g c c , where g is strictly increasing, concave, and homogeneous of degree one,

and v is strictly increasing and strictly concave. Define 1 2( , )c g c c to be an aggregate

consumption good and 1 2( , )p p p to be its unit cost function

1 2 1 1 2 2( , ) min p p p p c p c

1 2s.t. g( , ) 1c c (26)

0jc .

We next aggregate production of the two traded goods by defining the revenue function

1 2 1 1 1 1 2 2 2 2( , , ) max ( , ) ( , )i i i i ip p k p k p k

1 2s.t. i i ik k k (27)

1 2 1i i

0ijk , 0i

j .

This revenue function indicates, for any given prices of the two traded goods, the maximum

income that a country can obtain by allocating capital and labor over the production of the traded

goods. (See, for example, Dixit and Norman 1980, who refer to this function as the revenue

function; many other authors refer to it as the GDP function.) Figure 2 shows how the revenue

16

function is constructed. As is seen in the figure, this function is strictly increasing, concave, but

not strictly concave, and continuously differentiable but not twice continuously differentiable.

Using the first-order conditions for the revenue maximization problem (27), we obtain a

characterization of the relationship between factor endowments, factor prices, and production

patterns, which does not depend on the assumptions on the demographic framework. We state this

relationship here, which is standard in Heckscher-Ohlin theory, as it is used several times in the

paper.

Lemma 1. The optimal capital-labor ratios in interior solutions to the revenue maximization

problem depend only on relative prices:

2 1( / )ij

jij

kp p

, 1, 2j . (28)

If 1 2 1 2 2 1( / ) ( / )ip p k p p , then factor prices only depend on goods prices,

1 2 1 1 1 2 1 2 2 2 2 1( , ) ( ( / ),1) ( ( / ),1)K Kr p p p p p p p p (29)

1 2 1 1 1 2 1 2 2 2 2 1( , ) ( ( / ),1) ( ( / ),1)L Lw p p p p p p p p . (30)

If 1 2 1( / )ik p p , then country i produces only good 1, 1 2 1 1 1 2( , , ) ( ,1) ( , )i i iKr p p k p k r p p , and

1 2 1 1 1 2( , , ) ( ,1) ( , )i i iLw p p k p k w p p . If 2 2 1( / )ik p p , then country i produces only good 2,

1 2 2 2 1 2( , , ) ( ,1) ( , )i i iKr p p k p k r p p , and 1 2 2 2 1 2( , , ) ( ,1) ( , )i i i

Lw p p k p k w p p .

Finally, given a sequence of prices 1 2 1 1 2 1( , ), ( , ),...tt t t tp p p p p and an initial endowment

of capital 0ik , country i’s social planner takes the sequence of prices as given and solves

00 0

( ; ) max ( )i t itt

V k p v c

1 2 1 2s.t. ( , ) ( , , )i i it t t t t t tp p p c x p p k (31)

1 (1 )i i it t tk k x

0itc , 0i

tx

0ik given.

17

Notice that this problem is like that of a planner in a one-sector model, except that the analogue of

the production function, 1 2( , , )it t tp p k , changes every period as prices change, and consumption is

weighted by the price index 1 2( , )t tp p p . The next lemma relates the equilibrium of the model

economy and the solution to the social planner’s problem in (31).

Lemma 2: In a model with infinitely lived consumers that satisfies A.1–A.6, let the sequence

1 1 1 2, , , , ,i i i it t t t t tc c k x p p be the equilibrium consumption, investment, and capital stock in country i

and the equilibrium prices for the traded goods. Then, for any equilibrium prices

1 2 1 1 2 1( , ), ( , ),...tt t t tp p p p p , the country’s value function ( ; )tV k p is continuous, strictly

increasing, and strictly concave in k for all 0k . Furthermore, for each 1,...,i n , the sequence

, ,i i it t tc x k , where 1 2( , )i i i

t t tc g c c , solves the country planner’s problem (31) in which the prices are

the equilibrium prices and the initial capital stock is 0ik .

Lemma 2 says that the country value function 0( ; )V k p completely summarizes the

situation of a country i . We have not imposed conditions on 1 , 2 , f , and u to ensure that an

equilibrium of the world economy exists. It may be that the economy is so productive that the

representative consumer in some country can attain infinite utility, or it may be that the economy is

so unproductive that consumption in some country converges so quickly to 0 that the consumer can

attain no more than utility minus infinity. What lemma 2 says is that, if an equilibrium exists,

0( ; )V k p , not just for the initial endowments 0ik , 1,...,i n , but for all 0k , and that

( ; )tV k p has the characteristics of a dynamic programming value function.

The country social planner’s problem and associated value function ( ; )tV k p are even

closer to those of a planner in a one-sector growth model when the model is one-sector

aggregatable. In this case, 1 2( , ) 1t tp p p for any possible 1tp and 2tp . Notice that solving the set

of n planner’s problems and the fixed point problem is not an easy task. Theoretically, it is a

convenient way to write the problem, though, since it highlights the similarities between the

problems faced by each country. In particular, notice that the n countries’ social planner’s

problems — one for each country — have the same sequence of prices and differ only in the initial

18

endowments of capital, 0ik . Therefore, comparing equilibrium allocations of capital across

countries is equivalent to doing comparative statics with respect to 0ik on the planner’s problem

(31).

Proposition 3. In a model with infinitely lived consumers that satisfies assumptions A.1–A.6, let

itk , 'itk , 0,1,...t , be the equilibrium capital stocks for two countries i and 'i . Assume that

'0 0i ik k . Then 'i i

t tk k for all t . Furthermore, if 0itx , then 'i i

t tk k implies that '1 1

i it tk k .

The proof of proposition 3 applies a monotonicity argument similar to those of Milgrom and

Shannon (1994) to the country social planner’s problem, and it is given in the appendix.

Proposition 3 is powerful. It states that, under very general conditions, a country’s ordering with

respect to relative capital abundance does not change along the equilibrium path. Therefore, if the

Heckscher-Ohlin theorem holds, the patterns of trade cannot reverse along the equilibrium path.

In the rest of the section, we restrict our analysis to specific types of equilibria.

5.1. Steady states

In this section, we derive properties of steady state equilibria for the model with infinitely

lived consumers. These properties are standard in the literature on dynamic Heckscher-Ohlin

models where countries only differ in their initial factor endowments. Chen (1992), Baxter (1992),

and Bond, Trask, and Wang (2003) derive similar results in similar environments.

Definition 5. A nontrivial steady state is a steady state in which aggregate capital is positive,

1 1ˆ ˆ / 0

n ni i i

i ik L k L

, that is, ˆ 0ik , for some 1,...,i n .

Bajona and Kehoe (2010) construct an example in which 2 ( , )k and in which one country has

0 capital in the steady state but the other country has positive capital.

Proposition 4: In a model with infinitely lived consumers that satisfies A.1–A.6, there is factor

price equalization in any nontrivial steady state.

Proposition 5: In a model with infinitely lived consumers that satisfies A.1–A.6, if there exists a

nontrivial steady state, there exists a continuum of them. These steady states have the same prices

19

and the same aggregate capital-labor ratio, k̂ . The steady states are parameterized by the

distribution of capital per worker across countries, 1ˆ ˆ,..., nk k . Furthermore, international trade

occurs in every steady state in which ˆ ˆik k for some 1,...,i n .

Consider an economy that has an equilibrium converging to a steady state. Proposition 5

implies that the long-run equilibrium cannot be determined independently of initial factor

endowments. This is probably the reason why most existing papers introduce additional cross-

country differences (like different rates of time preference or different tax rates across countries),

which break down factor price equalization in steady state. We illustrate the dependence of the

steady state distribution of capital on its initial distribution with an example.

Example 1. Consider a discrete-time version of the model studied by Ventura (1997). There are

n countries. The production functions for the traded goods each use one factor of production;

1 1 1 1( , )k k , and 2 2 2 2( , )k . Assume that the model is one-sector aggregatable with a Cobb-

Douglas investment-consumption function, 11 2 1 2( , ) a af x x dx x . Our technology assumptions

ensure that factor price equalization always holds. Factor prices satisfy 1i

t t tr r p and

2it t tw w p . Furthermore, as long as there are no corner solutions in investment, we can use the

integrated approach to solve for equilibrium. To find the equilibrium of the integrated economy,

we solve the social planner’s problem

0max logt

ttc

1s.t. at t tc k dk (32)

0tc , 0tk

0 0k k .

The textbook solution to this problem, first obtained by Brock and Mirman (1972), is

1 1(1 ) /(1 )

1 0

t ta aa at tk adk ad k

, (1 )/(1 )

01 1t ta aa a

t tc a dk a d ad k . (33)

Using the first-order conditions, the feasibility conditions, and the solution (33), we obtain

1 1t tc a k , 2 1tc a (34)

20

1t tx ak , 2tx a (35)

11

at tp adk , 2 1 a

t tp a dk . (36)

To disaggregate across countries, we start by comparing the first-order conditions for the

country social planner’s problem (31) with those for the integrated economy equilibrium. (It is

here that the assumption of no corner solutions in investment is important.)

1 11 1 1

it t

t tit t

c cp r

c c

. (37)

Using (37) and the problem’s budget constraint, we can write the demand of the consumer in

country i in period t as

2 111

1(1 )

si it s ts t t

c p p kp

. (38)

Subtracting the analogous condition for the integrated economy, we obtain

1(1 ) ( )i it t t t tc c p k k . (39)

The budget constraints for country i and for the integrated economy imply that

1 1 (1 )( )i i it t t t t t tc c k k r k k . (40)

We can combine (37), (39), and (40) to obtain

1 11

( )i itt t t t

t

ck k k k

c

. (41)

Setting 1 / (1 ) /( )t t tz c k a a , 1, 2,...t , and 0 0 0 0/ (1 ) /( )z c r k a a , we obtain

1 1 1 1 0 0 0 0

1 0 0 0

i i i it t t t t t

t t t

k k z k k z k k k k

k z k z k k

, (42)

which implies that /it tk k is constant. Letting 0 0/i ik k , we can solve for 0 0/ic c to produce

1 1i i it tc a a a k , 2 1i i i

tc a a a (43)

1i it tx ak , 2

i itx a . (44)

21

Comparing levels of income per capita, measured in current prices, across countries, we

obtain

1 2

1 2

(1 )1

(1 )

i i iit t t t t t

t t t t t t

y p k p adk a dka a

y p k p adk a dk

. (45)

We now see the strong consequences of proposition 3. In a world of closed countries, we expect

every country to converge to the same steady state capital-labor ratio and level of income per

capita,

1/(1 )ˆ ak ad , /(1 )ˆ a a

y d ad , (46)

no matter what its initial endowment of capital. In a world of countries open to trade, however,

differences in initial endowments of capital lead to persistently different capital stocks and income

levels. In this example, in fact, differences stay proportionally fixed. As the world economy

converges to its steady state, each country converges to a steady state that depends on its initial

endowment of capital relative to the world average, 0 0/i ik k ,

1/(1 )ˆ ai ik ad , /(1 )ˆ 1

a ai iy a a d ad . (47)

5.2. Sustained growth paths

Equilibria in both one- and two-sector closed economy growth models can exhibit sustained

growth. (See, for example, Rebelo, 1991, for conditions under which this may occur.) Since our

model generalizes these closed economy models to a world with trade, sustained growth is also

possible here. The next proposition extends the results in the previous section to the limiting

behavior of equilibria that exhibit sustained growth.

Proposition 6: In a model with infinitely lived consumers that satisfies A.1–A.6, assume that there

exists an equilibrium in which 1 1lim / lim /i i i i it t t t t tk k c c for 0 i for all i and

1i for some i . Then i for all i . In this equilibrium with sustained growth, factor prices

are equalized in the limit. Furthermore, if there exists a sustained growth path, there is a continuum

of them, all of which have the same prices and aggregate capital-labor ratio, tk , but differ in the

initial allocation of capital per worker, 0ik , and the limiting distribution of capital across countries,

22

lim /it t tk k . International trade occurs in the limit of any equilibrium with sustained growth in

which lim / 1it t tk k for some 1,...,i n .

A limitation of proposition 6 is worth noting. Although sustained growth is defined in

terms of the infimum limit of 1 /i it tk k and 1 /i i

t tc c , the proposition, which characterizes the limiting

behavior of equilibria, requires that the limits of these variables exist. On the other hand, rather

than assuming that these limits are equal across countries, the proposition proves that they are

equal. Also worth noting is that the proposition does not rule out the possibility that

lim it tw . If lim i

t tw for some i , however, the proposition proves that it does so for all

i . Furthermore, it is easy to show that, even if lim it tw ,

1 1 2 2

lim 0it

t i it t t t

w

p y p y

. (48)

Consequently, even if the wage grows without bound, it does so slowly enough that, in the limit,

the economy behaves like an economy with no labor. (See Bajona and Kehoe 2010.)

The next example shows that the limiting distribution of capital in an equilibrium with

sustained growth depends on the initial distribution, just as example 1 does in the case of an

equilibrium that converges to a steady state.

Example 2. Consider a world economy identical to that in example 1 except that the production

function for consumption and investment is of the general CES form

1/

1 2 1 2 1 2( , ) ( , ) (1 )bb bg c c f c c d ac a c . (49)

Assume that 0b and 1/ 1ba d . To find the equilibrium of the integrated economy, we solve

the social planner’s problem:

0max logt

ttc

1/

1s.t. (1 )bb

t t tc k d ak a (50)

0tc , 0tk

0 0k k .

23

The equilibrium path for this problem exhibits sustained growth. Bajona and Kehoe (2010) show

that along this path 1 /t t tz c k decreases and that

1

1ˆ lim t

tt

cz

k

. (51)

The analogue of equation (42) holds:

0 0

0 0

i it t t

t

k k z k k

k z k

, (52)

although 0/tz z is not equal to 1 as it is in example 1. The limiting distribution of capital is

determined by the equation

0 0

0 0

ˆ ˆ ˆˆ

ii k kk k z

z kk

. (53)

5.3. Cycles and chaos

Equilibria in two-sector closed economy growth models do not need to converge to a steady

state or to a sustained growth path. Instead, the equilibrium may exhibit cycles or complex

dynamics. General conditions for the existence of two-period cycles in two-sector growth models

are presented by Benhabib and Nishimura (1985), and conditions for chaos are presented by

Deneckere and Pelikan (1986), Boldrin and Montrucchio (1986), and Boldrin (1989), among

others. In what follows, we present a specific example that has complex dynamics based on the

two-sector closed economy model developed by Boldrin and Deneckere (1990).

Example 3. Consider a world with two countries, each of which has a measure one of consumers.

Consumers have the period utility function

11 2 1 2( , )u c c c c , (54)

where 0.03 . The production function of the investment good uses the traded goods in fixed

proportions:

1 2 1 2( , ) min , /f x x x x , (55)

where 0.09 . The production for the traded goods is such that each of the traded goods uses

only one factor of production as in example 1. Furthermore, 1 .

24

Boldrin and Deneckere (1990) show that such an economy exhibits stable two-period cycles

for [0.093,0.095] and chaos for [0.099,0.112] . If 1 20 0k k , then the equilibrium of the

two-country economy coincides exactly with the equilibrium of the closed economy. If 1 20 0k k , if

one country finds it optimal to increase its capital stock, so does the other country. Therefore,

capital-labor ratios in both countries cycle in the same direction, mimicking the oscillations of the

integrated equilibrium. Chen (1992) makes a similar argument for a different model.

Notice that in this example, u is not strictly concave and f is not continuously

differentiable. Given that the property of having cycles or chaos is structurally stable, however, it

would be easy to perturb the utility and investment functions to construct examples that satisfy

assumptions A.3 and A.5 and that have equilibria with cycles or chaos.

The methodology used in this example is general and allows the construction of a two-

country trade model starting from any closed economy model with a consumption sector and an

investment sector, such as the model developed by Uzawa (1964). Let ( , )g k be the production

function for the consumption good, ( , )f k be the production function for the investment good,

and ( )c be the utility function in the two-sector closed economy model. We set 1( , )k k ,

2 ( , )k , and 1 2 1 2( , ) ( , )u c c v g c c .

In the cycle in example 3, factor prices are equalized in every period. In fact, this is the

only sort of equilibrium cycle that is possible, at least if investment is positive.

Proposition 7: In a model with infinitely lived consumers that satisfies A.1–A.6, assume that there

exists an equilibrium s-period cycle, 1 s with 0itx for all i and all t . Then factor price

equalization occurs in every period of the cycle.

To prove this proposition in the appendix, we argue that, if an equilibrium with a finite cycle exists,

countries have to change relative factor abundance at least once over the cycle. This implies that

they have to change relative factor abundance an infinite number of times along the equilibrium

path, which contradicts proposition 3.

As we have seen in lemma 2 and example 1, if consumers aggregate the two traded goods to

obtain utility in the same way that firms aggregate these goods to obtain investment, then the

equilibrium allocation of the integrated economy solves a one-sector social planner’s problem.

25

Although the integrated economy approach to characterizing equilibria applies only when we can

ensure factor price equalization, the assumption of one-sector aggregatability (made by Ventura

1997 and Bajona and Kehoe 2010, among others) coupled with proposition 7 puts strong

restrictions on equilibrium dynamics.

Proposition 8: Assume that a model with infinitely lived consumers satisfies A.1–A.6 and is one-

sector aggregatable. Also assume that 0itx for all i and all t . Then there cannot exist an

equilibrium with cycles.

6. A dynamic Heckscher-Ohlin model with overlapping generations

Departures from basic Heckscher-Ohlin assumptions are stronger in dynamic versions of

the model made under an overlapping generations framework. For instance, it is common in the

literature to depart from the assumption of identical consumers and to assume that consumers in

different countries differ in their rates of time preference (Galor and Lin 1997, Mountford 1998).

In this section, we derive some general results for equilibrium paths of our overlapping generations

model, which do not include any of these additional assumptions. In view of the results, we also

rationalize the reasons why these assumptions are made. Heckscher-Ohlin models with

overlapping generations are significantly different from infinitely lived consumer models. They

exhibit a richer variety of possible behavior, in the same way as they do in closed economy

settings.1

6.1. Steady state analysis

A dynamic Heckscher-Ohlin model with overlapping generations may have steady states in

which factor prices do not equalize. If prices do equalize in a given steady state, however, then all

countries behave in exactly the same way and there is no trade. This result is in sharp contrast to

propositions 4 and 5, which state that in the infinitely lived model, factor prices equalize in any

steady state and that international trade occurs in (almost all) steady states. In the overlapping

generations model, steady states with factor price equalization are not “interesting”: any

equilibrium converging to them has no trade in a finite number of periods. Therefore, in order to

1 It is also worth noting that, in closed economy models with infinitely lived consumers, equilibria are generically determinate, wheras in closed economy models with overlapping generations, there are robust examples with indeterminate equilibria. (See Kehoe and Levine 1985 and the related literature.) Although these sorts of results can be expected to carry over to dynamic Heckscher-Ohlin models, we do not pursue these matters in this paper.

26

have factor price equalization and trade in the long run in an overlapping generations environment,

the basic assumptions of the model (countries are identical except in their initial endowments) need

to be modified. This is what is done in the existing literature.

Proposition 9: In a model with overlapping generations that satisfies assumptions A.1–A.4 and

A.5'–A.6', assume that there is a nontrivial steady state in which factor prices equalize. Then

ˆ ˆik k is in the interior of the cone of diversification and there is no international trade in this

steady state.

Proposition 10: In a model with overlapping generations that satisfies assumptions A.1–A.4 and

A.5'–A.6', any equilibrium that converges to a steady state in which there is factor price

equalization reaches factor price equalization and no trade within a finite number of periods. In

particular, the equilibrium becomes autarkic once all generations alive have been born under factor

price equalization.

As in the infinitely lived consumer environment, these results can be extended to economies

with equilibria that converge to sustained growth paths.2

6.2. General structure of examples

As we have mentioned, overlapping generations economies can have steady states where

factor prices do not equalize across countries. In what follows, we describe a general methodology

for the construction of model economies with such properties starting from one-sector closed

economy models. We then use our methodology to derive four different examples that have steady

states without factor price equalization.

The general structure of our examples is that of a model with two countries, 1, 2i with

CES production functions for the traded goods:

1/( , ) (1 )j j j j j jk k

, (56)

for 1 , 0 , and

2 Sustained growth is harder to obtain in the overlapping generations environment. In particular, sustained growth can occur only for economies that are not one-sector aggregatable and under strong conditions (see Jones and Manuelli, 1992, and Fisher, 1992, for details.)

27

1( , ) j j

j j j jk k (57)

for 0 . The production function for the investment good is Cobb-Douglas:

11 2 1 2( , ) a af x x dx x , (58)

where 0 1a . Capital depreciates completely, 1 .

On the consumers’ side, we assume that there is a measure one of consumers of each

generation in each country 1 2 1L L . The representative consumer in each generation t in

country i lives for two periods, has labor endowments 1 2( , ) , and has the utility function

1 1

1 1 2 2 1 1 2 1log loga a a at t t t

t t t tc c c c

. (59)

Notice that this model is one-sector aggregatable, since the parameter a in the utility function is

the same as that in the production function for the investment good.

To find the cone of diversification for any given prices, we calculate the optimal capital-

labor ratios in interior solutions to the revenue maximization problem (27). The solution is

1/(1 ) 1/1/(1 ) /(1 ) 1/(1 ) /(1 )

1 2 2 2 1 1 11 2 1 1/(1 ) /(1 ) 1/(1 ) /(1 )

1 1 1 2 2 2 1

(1 ) ( / ) (1 )( / )

1 ( / )

p pp p

p p

(60)

and

1/(1 )

2 12 2 1 1 2 1

2 1

1( / ) ( / )

1p p p p

, (61)

for 0 . When 0 , these functions become

1 22 2

1/( )1

2 2 1 2 21 2 1

1 1 1

/ 1( / )

1

p pp p

(62)

and

2 12 2 1 1 2 1

2 1

1( / ) ( / )

1p p p p

. (63)

28

Let us write 2 , 1 , 2 , and 1 for 0 1 , 0 , 0 , and

R . This relationship between the parameters allows us to express the capital-labor ratios that

determine the cone of diversification as functions of , , , and . Notice that 0

guarantees that good 1 is the capital intensive good. Together with the endowments of capital and

labor, the parameters , , , , d , and a determine the pattern of specialization and trade.

Notice that as approaches 0, the production functions for the two traded goods become more

similar. The cone of diversification narrows, collapsing into a straight line when 0 . Setting

2 1/ 1p p and using l’Hôpital’s rule to take limits as tends to 0, we obtain:

1/

1 2

(1 )(1) (1)

(64)

for 0 , and

/1 2(1) (1) e (65)

for 0 . By choosing appropriately, we can make this degenerate cone of diversification pass

through any point. Furthermore, setting 1 2 1p p determines the values of d and a as

functions of , , , and . Appendix 3 provides details on this derivation.

We derive each of our examples starting with a one-sector, closed-economy, overlapping

generations model that has multiple steady states. Let 2 ( , )k be the production function of this

model. Let 2 and 2 be the parameters of this production function. We then construct

another one-sector, closed economy model that preserves the steady state behavior of the original

model by slightly perturbing this production function. Let 1( , )k with parameters 1 and

1 be the production function of this perturbed model. The key is to find values of and

so that there exists a steady state of the original model with capital-labor ratio and factor prices

2 2 2ˆ ˆ ˆ( , , )k r w and a steady state of the perturbed version of the model with capital-labor ratio and

factor prices 1 1 1ˆ ˆ ˆ( , , )k r w that satisfy

1 2ˆ ˆk k , 1 2ˆ ˆr r , and 1 2ˆ ˆw w (66)

and

either 11

ˆ (1)k or 22

ˆ (1)k or both. (67)

29

Condition (67) implies that, in a two-sector, two-country economy with production functions

1( , )k and 2 ( , )k , at least one country specializes in production if prices are 1 2 1p p and

countries’ capital-labor ratios are ˆ ik , 1, 2i . Condition (66) implies that ˆir and ˆ iw are consistent

with lemma 1, that is, the capital intensive country has a lower rental rate of capital. We can

choose and so that condition (67) holds. Specifically, we choose so that the cone of

diversification passes between the steady state 2k̂ of the original one-sector model and the steady

state 1k̂ of the perturbed one-sector model when 0 and then increase . Whether or not

condition (66) holds in the constructed two-sector model depends on the properties of the original

one-sector model, as we will see in the examples in the next section.

6.3. Steady state examples

Using the methodology developed in the previous section, we construct four examples of

two-country economies that have steady states where factor prices are not equal across countries.

In the first two examples, there is positive fiat money in one of the countries but not the other. In

the other two examples, there is no fiat money.

Example 4. Consider a one-sector, closed economy model where the representative consumer in

generation t has the utility function

1log 2logt tt tc c (68)

and the labor endowment is 1 2( , ) (0.8,0.2) . The production function is Cobb-Douglas:

0.25 0.752 ( , ) 4k k . (69)

This economy has two steady states: a steady state with no fiat money where ˆ 0b , ˆ 1.4675k ,

ˆ 0.75r , and ˆ 3.3019w and a steady state with positive fiat money where ˆ 0.4b , ˆ 1k , ˆ 1r ,

and ˆ 3w . Notice that the steady state without fiat money has a higher capital-labor ratio, a lower

rental rate, and a higher wage than does the steady state with fiat money, allowing us to construct

an example that satisfies lemma 1.

To construct the perturbed economy, let us set 0.05 and 0.8 . Then, 1 becomes

0.3 0.71( , ) 3.96k k . (70)

30

The perturbed economy also has two steady states. The steady state without fiat money has ˆ 0b ,

ˆ 1.4219k , ˆ 0.9286r , and ˆ 3.0807w .

Consider now a two-country, two-sector economy where good 1 has production function 1

and good 2 has production function 2 . The cone of diversification for the two-country economy

for 1 2ˆ ˆ 1p p is determined by 2ˆ (1) 1.0757 and 1̂(1) 1.3830 . Set the steady state capital-

labor ratio in country 1 to 1ˆ 1.4219k (the non-monetary steady state of the perturbed economy)

and in country 2 to 2ˆ 1k (the monetary steady state of the perturbed economy). We now have a

steady state of the two-country, two-good economy where country 1 specializes in the production

of good 1, producing 11ˆ 4.4010y and 1

2ˆ 0y , and country 2 specializes in the production of good

2, producing 21ˆ 0y and 1

2ˆ 4y . Figure 3 depicts the cone of diversification for this world

economy. Finally, to have 1 2 1p p in steady state, we need 1.9977d and 0.5239a . Factor

prices do not equalize in this steady state: 1ˆ 0.9286r and 1ˆ 3.0807w , but 2ˆ 1r and 2ˆ 3w .

The calculation of the other variables is straightforward. Since 1̂ 1.0427c and 2ˆ 1.9364c

in the steady state of the perturbed one-sector economy, for example, and

1 2 1 2 1 21 1 1 1 2 2ˆ ˆ ˆ ˆ ˆ ˆ( ) /( ) 4.4010/8.4010 0.5239y y y y y y , we set 1

11ˆ (0.5239)1.0427 0.5462c ,

121ˆ (1 0.5239)1.0427 0.4965c , 1

12ˆ 1.0144c , and 122ˆ 0.9220c . Similarly, since

1 1ˆˆ 1.4219x k , we set 11̂ 0.7449x and 1

2ˆ 0.6770x . Notice that trade is balanced: country 1

exports 1 1 1 11 11 12 1ˆ ˆ ˆ ˆ 2.0955y c c x of good 1 and imports 1 1 1 1

21 22 2 1ˆ ˆ ˆ ˆ 2.0955c c x y of good 2.

Example 5. Consider a modification of example 4 where 1 3.92 (achieved by setting 1.6 ).

The cone of diversification is now determined by 2ˆ (1) 1.3179 and 1̂(1) 1.6944 , and

1ˆ 1.4507k is in its interior, as depicted in figure 4. In this steady state, country 1 diversifies in

production, producing 11ˆ 1.6201y and 1

2ˆ 2.7736y , and country 2 specializes in the production of

good 2, producing 21ˆ 0y and 1

2ˆ 4y . To ensure that 1 2ˆ ˆ 1p p , we set 1.6332d and

0.1930a . Factor prices do not equalize: 1ˆ 0.8130r and 1ˆ 3.2143w , but 2ˆ 1r and 2ˆ 3w .

Example 6. Consider now a model with the same utility function and labor endowments as in

examples 4 and 5, but where the production function is

31

1/33 32 ( , ) 4 0.25 0.75k k

. (71)

The one-sector closed economy model has three steady states. In one steady state, ˆ 0.4b and

ˆ 1k . In the other two, ˆ 0b and either ˆ 0.5675k or ˆ 1.3355k . When ˆ 0.5675k , ˆ 0.75r

and ˆ 3.3019w , and, when ˆ 1.3355k , ˆ 0.75r and ˆ 3.3019w , allowing us to construct an

example that satisfies lemma 1.

Let us set 0.05 and 0 , so that the production function for the perturbed economy is

1/33 31( , ) 4 0.3 0.7k k

. (72)

The perturbed economy also has three steady states: one steady state with positive fiat money and

two steady states with no fiat money.

The cone of diversification is now determined by 2ˆ (1) 0.9687 and 1̂(1) 1.0315 . Set

the capital-labor ratio in country 1 to 1ˆ 1.3908k , which is the perturbation of the steady state of

the one-sector model where ˆ 1.3355k , and set the capital-labor ratio in country 2 to 2ˆ 0.5675k .

Country 1 specializes in good 1, producing 11ˆ 4.2884y and 1

2ˆ 0y , and country 2 specializes in

the production of good 2, producing 21ˆ 0y and 1

2ˆ 3.1147y . To ensure that 1 2ˆ ˆ 1p p , we set

1.9749d and 0.5793a . Factor prices do not equalize: 1ˆ 0.4237r and 1ˆ 3.6991w , but

2ˆ 3.5452r and 2ˆ 1.1029w .

The essential step in the construction of example 6 is to start with a one-sector closed

economy model that has multiple steady states without fiat money. It is impossible to do this with

a model with logarithmic utility and Cobb-Douglas production. Consider such a model with

production function 12( , )k k , utility function 1 2 1log logt t

t tc c , and labor endowments

1 2( , ) . The unique steady state without fiat money is determined by

11 1

22

1 1 2

(1 )ˆ(1 )

k

, (73)

and the rental rate of capital is given by

1 21 1 2

2 1 2 1

ˆˆ(1 )

r k

. (74)

32

6.4. Cycles and chaos

To complete our analysis, we use the methodology developed in section 6.1 to construct

two examples with a two-period cycle as a steady state: one in which both countries completely

specialize in each period and one in which one of the countries diversifies in each period.

Example 7. We start by constructing a one-sector, pure exchange economy with an equilibrium

two-period cycle. In this economy the representative consumer in generation t solves the problem

41( )

max 1004

tt tt

cc

1s.t. 0.8t tt tc b (75)

1 1 10.2 (1 )t bt t tc r b

0ttc , 1 0t

tc .

We can think of this economy as a production economy with the production function y and the

labor endowments 1 2( , ) (0.8,0.2) . This economy has an equilibrium cycle of periodicity 2,

with 1 ˆˆ ˆ ˆ( , , , )t tt t t tc c r b cycling between

1 21 1 1 1̂ˆ ˆ ˆ( , , , ) (0.7670,0.2330, 0.9314,0.4803)bc c r b (76)

and

2 1 22 2 2 2̂ˆ ˆ ˆ( , , , ) (0.3197,0.6803,13.5766,3.295 10 )bc c r b . (77)

Notice that 1 2ˆ ˆ(1 )(1 ) 1b br r . Figure 5 depicts this cycle in an offer-curve diagram. The figure

graphs the set of excess demands 1( , ) ( 0.8, 0.2)t t t tt ty z c c that are utility maximizing for some

1b

tr and the set of ty and tz that satisfy the feasibility condition 1 0t tz y . (See, for example,

Kehoe 1989.)

The next step is to perturb this economy to allow production in which capital plays a role:

5/33/5 3/52 ( , ) 0.1 0.9y k k . (78)

33

This one-sector economy with production has a cycle of periodicity 2, with ˆ ˆ ˆ ˆ( , , , )t t t tk r w m cycling

between

1 1 1 1ˆ ˆˆ ˆ( , , , ) (0.2214,0.1754,0.8639,0.3958)k r w b (79)

and

5 22 2 2 2

ˆ ˆˆ ˆ( , , , ) (3.422 10 ,5.6996,0.8391,6.945 10 )k r w b . (80)

Notice that 1 2ˆ ˆ 1r r .

We add another sector by perturbing production function in much the same way that we did

in the steady state examples in the previous section:

5/33/5 3/51( , ) 1.09 0.15 0.85y k k . (81)

That is, we set 0.05 and 1.8 . The two-sector economy has a two-period cycle where

1 2 1p p over the cycle and countries alternate their positions between

21 1 1 1ˆ ˆˆ ˆ( , , , ) (9.726 10 ,0.3834,0.8554,0.3137)k r w b (82)

and

42 2 2 2

ˆ ˆˆ ˆ( , , , ) (2.418 10 , 2.6083,0.8394,0.1203)k r w b . (83)

The cone of diversification for this economy is determined by 32ˆ (1) 8.452 10 and

21̂(1) 2.687 10 . When a country has capital 2

1̂ 9.726 10k , it specializes in the production of

good 1, producing 11ˆ 0.8926y and 21ˆ 0y , and, when it has capital 42

ˆ 2.418 10k , it

specializes in the production of good 2, producing 12ˆ 0y and 22ˆ 0.8400y . In the equilibrium

cycle, countries change their specialization pattern every period. Because the countries are

symmetric and alternate between the same two positions, the relative production of the two goods

stays constant, which allows us to ensure that 1 2 1p p by setting 1.9991d and 0.5151a .

Example 8. This example slightly modifies the production function of good 1 in example 7 so that

one of the countries diversifies in production. In particular, we set 1 1.07 by setting 1.4 .

34

The cone of diversification is now determined by 22

ˆ (1) 5.637 10 and 1̂(1) 0.1792 . This

economy has a cycle where countries alternate their positions between

1 1 1 1ˆ ˆˆ ˆ( , , , ) (0.1391,0.2984,0.8500,0.3388)k r w b (84)

and

42 2 2 2

ˆ ˆˆ ˆ( , , , ) (1.291 10 ,3.3515,0.8392,0.1011)k r w b . (85)

When a country has capital 1̂ 0.1391k , it now diversifies, producing 11ˆ 0.6084y and

21ˆ 0.2830y , and, when it has capital 42

ˆ 1.291 10k , it specializes in the production of good 2,

producing 12ˆ 0y and 22ˆ 0.8397y . Countries enter and exit the cone of diversification an infinite

number of times. To ensure that 1 2 1p p , we set 1.9124d and 0.3515a .

Examples 7 and 8 illustrate the richness of possible equilibrium behavior of dynamic

Heckscher-Ohlin models with overlapping generations. In particular, the examples have long-run

equilibria without factor price equalization in models that are one-sector aggregatable (in one of

them, the countries leave the cone an infinite number of times). Propositions 7 and 8 show that this

type of example cannot be constructed in models with infinitely lived consumers.

As a final note, we observe that, as in the infinitely lived consumer environment, any two-

sector, closed economy model with overlapping generations can be made into a trade model.

Suppose that ( , )g k is the production function for the consumption good in the two-sector closed

economy model, that ( , )f k is the production function for the investment good, and that ( )h c is

the utility function in period of life h . Set 1( , )k k , 2 ( , )k , and 1 2 1 2( , ) ( ( , ))h hu c c v g c c .

Since the cone of diversification is the entire nonnegative quadrant, factor prices equalize in any

equilibrium. The equilibrium is autarkic after 1m periods, where m is the length of a

consumer’s life. Consequently, all of the possibilities for equilibrium dynamics that are present in

two-sector growth models with overlapping generations are also present in our model. In

particular, two-sector, closed-economy models with cyclical and chaotic behavior, like those

constructed by Reichlin (1992), can be made into examples of Heckscher-Ohlin economies.

35

Appendix 1: Equations that characterize equilibrium

Common to both environments:

1,...,i n , 0,1,...t

1 2( , )i i it t tx f x x (86)

1 1i i it t tk k x (87)

1 2 1i it t (88)

1 2i i it t tk k k . (89)

1, 2j

( , )i i ijt j jt jty k (90)

( , )i i it jt jK jt jtr p k , if 0i

jtk (91)

( , )i i it jt jL jt jtw p k , if 0i

jt (92)

1 2( , )i ijt j t tp f x x . (93)

Specific to infinitely lived consumer environment:

1,...,i n

0 0i ik k , 0 0ib (94)

0,1,...t

2 1 2 2

1 1 2 1

( , )

( , )

i it t t

i it t t

u c c p

u c c p (95)

1 1 2 1 11 1

1 1 1 2 1 1 1 1 1

( , )(1 ) (1 )

( , )

i ibi it t t t

t ti it t t t

u c c p pr r

u c c p p

, if 0itx (96)

1 1 2 2 1 1 (1 ) (1 )i i i i i b i i it t t t t t t t t t tp c p c x b w r b r k (97)

1, 2j

1 1

( )n ni i i i i

jt jt jti iL c x L y

. (98)

If there is international borrowing and lending,

1

0n i i

tiLb

(99)

bi bt tr r . (100)

If there is no international borrowing and lending,

36

0itb . (101)

Specific to overlapping generations environment:

1,...,i n

0 0ih ihk k , 0 0

ih ihb b , 1 ,..., 1h m (102)

0,1,...t

1 1

1

mi it ht th

x x

(103)

1

2

mi it ht th

k k

(104)

1, 2j

1

1 1 1

n m ni it h i i ijt jt jti h i

L c x L y

(105)

1,...,h m

1 1

2 1 2 21 1

1 1 2 1

( , )

( , )

it h it ht t t

it h it ht t t

u c c p

u c c p

(106)

1 1 1 1 1 11 1 2 2 1 1 (1 ) (1 )it h it h it h it h i h bi it h i it ht t t t t t t t t t tp c p c x b w r b r k

(107)

1,..., 1h m

1 1 11 1it h it h it h

t t tk k x (108)

1 1

1 1 2 1 11 11 1

1 1 1 1 2 1 1 1 1 1

( , )(1 ) (1 )

( , )

it h it hbi ih t t t t

t tit h it hh t t t t

u c c p pr r

u c c p p

, 1if 0it htx . (109)

If there is international borrowing and lending,

1101 2 1 10

(1 )tn m ni it h b i ih

t si h i h msL b r L b

(110)

bi bt tr r , (111)

and the initial amount of fiat money is 1

01 1

n i ih

i h mL b

.

If there is no international borrowing and lending,

1102 10

(1 )tm it h bi ih

t sh h msb r b

, (112)

and the initial amount of fiat money per capita in country i is 1

01

ih

h mb

.

37

Appendix 2: Proofs

Proof of proposition 1: The first-order conditions for the consumers’ problems, (6) or (15) and (16), imply the no-arbitrage condition i b

t tr r for all 0t . Consequently, rental rates of capital

are equalized for all 0t . Since both goods are produced and each country produces at least one good, pick two countries, say 1 and 2, such that country 1 produces good 1 and country 2 produces good 2. Let ( , )j t tp r w be the unit cost function in sector j . Since country 2 produces good 2,

2 12 2 2( , ) ( , )t t t t tp p r w p r w . Since 2 is capital intensive, 2 is strictly increasing in labor, which

implies that 2p is strictly increasing in the wage. This implies that 1 2t tw w .

There are two cases to examine. First, suppose that 1 is also strictly increasing in labor.

Then 1 21 1 1( , ) ( , )t t t t tp p r w p r w where 1p is strictly increasing in the wage. This implies that

1 2t tw w . Consequently, 1 2

t tw w . Second, suppose instead that 1 is not strictly increasing in

labor. Then it cannot employ labor at a positive wage. Since 1 2t tw w , if 1 2

t tw w , then 1 2t tw w .

Consequently, country 1 must also produce good 2, which implies that 2 12 2 2( , ) ( , )t t t t tp p r w p r w .

Since 2 is strictly increasing in labor, this implies that 1 2t tw w . ■

Proof of proposition 2: We prove the proposition for the model with infinitely lived consumers. The proposition for the model with overlapping generations follows the same argument with changes in notation. Assume that an equilibrium 1 2{ , , , , }i i i

t t t t tp p q w r , 1 2{ , , , , }i i i i it t t t tc c x k b ,

{ , , }i i ijt jt jty k , 1 2{ , , }i i i

t t tx x x exists in which 0itx for all i and all .t We provide a method for

constructing an infinite number of equilibria that have the same values of all variables in all periods except for s and 1s . In periods s and 1s , we keep the values of prices 1tp , 2tp , 1i

tq , itw , i

tr ,

consumption 1itc , 2

itc in individual countries, and of aggregate production and investment fixed.

We change 1isk to 1

isk so as to change the production plans 1

ijsy , 1

ijsk , 1

ijs to 1

ijsy , 1

ijsk , 1

ijs ,

1, 2j . To accumulate the capital stock 1isk , we set 1 (1 )i i i

s s sx k k , ( / )i i i ijs s s jsx x x x , 1, 2j .

To satisfy the budget constraint, we set 1 1 1 1i i i is s s sb x b x . We then set 1 2 1(1 )i i i

s s sx k k ,

1 1 1 1( / )i i i ijs s s jsx x x x , 1, 2j . It is easy to check that the budget constraint in country i period

1s is satisfied because the constraint in s is satisfied.

To find nonnegative production plans 1ijsy , 1

ijsk , 1

ijs consistent with profit maximization

at the equilibrium prices 1 1sp , 2 1sp , 1sw , 1sr , the capital-labor ratio 1isk needs to be in the cone

of diversification,

1 2 1 1 1 1 2 2 1 1 1( / ) ( / )is s s s sp p k p p . (113)

We also want to keep investment nonnegative in periods s and 1s ,

1 (1 )i is sk k (114)

1 2 /(1 )i is sk k . (115)

38

Together, these inequalities become

1 2 1 1 1 1 1 2 2 1 1 1min ( / ), /(1 ) max ( / ), (1 )i i is s s s s s sp p k k p p k

. (116)

Assumption A.2 ensures that the cone of diversification has an interior,

1 2 1 1 1 2 2 1 1 1( / ) ( / )s s s sp p p p . (117)

Since we have assumed that 0itx for , 1t s s ,

2 1/(1 ) (1 )i i is s sk k k . (118)

Proposition 1 ensures that 1isk is in the cone of diversification, although it may be on the

boundary. Therefore, 1isk satisfies inequality (116) and

1 2 1 1 1 1 2 2 1 1 1min ( / ), /(1 ) max ( / ), (1 )i is s s s s sp p k p p k . (119)

Consequently, we can set 1 1i i is sk k for some nonzero i small enough and still satisfy

inequality (116). If 2 1 2 1 1 1 1/(1 ) ( / )i i

s s s sk p p k , then we have to set 0i , and, if

2 2 1 1 1 1(1 ) ( / )i is s s sk p p k , then we have to set 0i . Otherwise, we have freedom to set

1n values of i independently. We want to keep the aggregate capital stock the same,

1 11 11

1 1

( )n ni i i i i

s si isn ni i

i i

L k L kk

L L

, (120)

which implies that

1

1( / )

nn i n i

iL L

. (121)

There are two possible cases. First, 1nsk is in the interior of the cone of diversification, in which

case, by choosing i , 1,..., 1i n , small enough, we can ensure that 1

1 1 1( / )

nn n i n is s i

k k L L

stays in the cone. Second, 1nsk is on the boundary of the cone, in which case, if we can choose

some of the deviations i , 1,..., 1i n , to be positive and others negative, we can set them so that n has any desired sign. If all of the deviations i , 1,..., 1i n , have to be of the same sign, then

we know that all of the capital-labor ratios 1isk , 1,..., 1i n , are on the same boundary of the

cone. Since 1 11 1/

n ni i is si i

k L k L is in the interior of the cone, however, this implies that 1

nsk ,

if it is on a boundary of the cone, is on the other boundary, which implies that n has the desired sign.

By reshuffling savings between capital and bonds, we have shown that there is an 1n dimensional indeterminacy in any period 1s for which 0i

tx for all i in periods s and 1s . If

0itx in either of these periods for some country i , then it could be that

39

1 2 1 1 1 1 2 2 1 1 1min ( / ), /(1 ) max ( / ), (1 )i is s s s s sp p k p p k , (122)

which would imply that we have to set 0i and would reduce the dimension of indeterminacy by 1 in period 1s . Notice that, if =1, then equation (122) can never hold, and we always have an

1n dimensional indeterminacy in every period 0t . ■

Proof of lemma 1: The result follows directly from the first-order conditions for the revenue maximization problem (27) and the strict concavity of j . See, for example, Dixit and Norman

(1980). ■

Proof of lemma 2: Suppose that the country social planner’s problem (31) is well posed in the

sense that there is a feasible { , , }i i it t tc x k such that

0lim inf ( )t i

T ttv c

and there is no

feasible { , , }i i it t tc x k such that

0lim sup ( )t i

T ttv c

. We can show that the equilibrium

{ , , }i i it t tc x k solves the country planner’s problem (31) in which the prices 0p are the equilibrium

prices and the initial capital stock is 0ik by showing that the equilibrium conditions imply that the

first-order conditions and transversality condition of (31) are satisfied. Furthermore, if V is well defined in the sense that 0( ; )V k p for all 0k , then it is straightforward to use the sorts of arguments in Stokey, Lucas, and Prescott (1989) to show that the properties of v and imply that V is continuous, increasing, and concave as a function of k . Consequently, to prove the theorem we need to argue that 0( ; )V k p for all 0k . Notice that 0

0( ; )iV k p is finite

when the prices 0p are the equilibrium prices and the initial capital stock in country i is 0ik .

Similarly, ( ; )i ttV k p is finite for any i

tk on the equilibrium path. Otherwise, the consumer’s

problem (6) would not be well posed and the prices 0p would not be the equilibrium prices.

We first argue that 0( ; )V k p . Suppose, to the contrary, that 00

ˆ( ; )V k p for some

0̂ 0k , and let ˆˆ ˆ{ , , }t t tc x k be the corresponding plan for consumption, investment, and the capital

stock. If 0 0ˆ maxik k , where 0 0

maxi ik k , 1,...,i n , we could reduce 0maxik to 0k̂ , follow the plan

ˆˆ ˆ{ , , }t t tc x k , and achieve infinite utility in equilibrium, which implies that the prices 0p cannot be

equilibrium prices. If 0 0ˆ maxik k , then assumption A.5 implies that we can reduce 0

maxic to 0c ,

0 0 0maxic c , and increase 0maxix to 0 0

maxix x , thereby increasing 1maxik to 1k . Consider the

continuation plan

ˆˆ ˆ( , , ) ( (1 ) , (1 ) , (1 ) )max max maxi i it t t t t t t t tc x k c c x x k k , 1, 2,...t , (123)

where 1 1 1 1ˆ ˆ( ) /( )maxik k k k . Since { , , }max max maxi i i

t t tc x k satisfies the feasibility conditions in problem

(31) for the initial capital 0maxik and ˆˆ ˆ{ , , }t t tc x k satisfies the feasibility for the initial capital 0k̂ ,

{ , , }t t tc x k satisfies the feasibility conditions for initial capital 0maxik . Notice that, although

0 0( ) ( )maxiv c v c , the strict concavity of v implies that

1 1 1 1

ˆ ˆ( ) ( (1 ) ) ( ) (1 ) ( )max maxi it t t tt t t t tt t t t

v c v c c v c v c

, (124)

40

which again implies that the prices 0p cannot be equilibrium prices.

We now argue that 0( ; )V k p . Suppose, to the contrary, that 00

ˆ( ; )V k p for some

0̂ 0k . If 0 0ˆ minik k , where 0 0

mini ik k , 1,...,i n , we could reduce 0k̂ to 0minik , follow the

equilibrium plan { , , }min min mini i it t tc x k and achieve a finite value of the objective function in problem

(31), which implies that 00

ˆ( ; )V k p . If 0 0ˆ minik k , consider the plan , ,min min mini i i

t t tc x k , where

0 0ˆ / minik k . Since { , , }min min mini i i

t t tc x k is feasible for initial capital 0minik , { , , }min min mini i i

t t tc x k is feasible

for initial capital 0k̂ and

00 0

ˆ( ; ) ( )minittt

V k p v c

. (125)

The strict concavity of v implies that

0 0 0

( ) ( ) (1 ) '( )min min min mini i i it t tt t t tt t t

v c v c v c c

. (126)

Since , ,min min mini i it t tc x k is an equilibrium plan, we know that

0( )minit

ttv c

and that

01 20 0 1

10 20

'( ) 10 '( ) ( , )

( , ) 1

min

min min min

min

iti i it

t t t t tit t ss

v cv c c p p p c

p p p r

. (127)

(In fact, the latter term is the present discounted value in period 0 of consumption in mini .)

Consequently, 00

ˆ( ; )V k p . ■

Proof of proposition 3. The proof follows the approach of Milgrom and Shannon (1994). We prove that '

0 0i ik k implies '

1 1i ik k . By induction, the argument extends to any other period. Let us

write the country social planner’s problem as

0 0 10 0 0 1 1( ; ) max ( ( , ; )) ( ; )i i i iV k p v c k k p V k p (128)

01 0s.t. 0 ( ; )i ik k k p ,

where 00 0 1 10 20 0 1 0 10 20( , ; ) ( ( , , ) (1 ) ) / ( , )i i i i ic k k p p p k k k p p p , and

00 10 20 0( ; ) ( , ) (1 )i ik k p p p k . Define 0 0 1

0 1 0 0 1 1( , ; ) ( ( , ; )) ( ; )i i i i iF k k p v c k k p V k p . We prove

our result by contradiction. If '0 0i ik k , then '

1 1i ik k . Therefore, assume, without loss of generality,

that 1 20 0k k and 1 2

1 1k k . Notice that, since 1 2 2 0 1 01 1 0 0( ; ) ( ; )k k k k p k k p , both 1

1k and 21k are

feasible. Since 1ik maximizes 0

0 1( , ; )i iF k k p , 1, 2i , we know that

1 1 0 1 2 0 2 1 0 2 2 00 1 0 1 0 1 0 1( , ; ) ( , ; ) 0 ( , ; ) ( , ; )F k k p F k k p F k k p F k k p . (129)

Define the function 1 0 2 00 0 1 0 1( ) ( , ; ) ( , ; )g k F k k p F k k p .

1 0 2 0 10 20 0

0 0 0 1 0 0 110 20

( , , ) 1( ) ( , ; ) ( , ; ) 0

,k p p k

g k v c k k p v c k k pp p p

, (130)

41

where 10 20 0( , , )k p p k is the partial derivative of 10 20 0( , , )p p k with respect to 0k . The inequality

follows from the fact that v is strictly concave and 0c is strictly increasing in 1k . Therefore, 1 20 0k k implies 1 2

0 0( ) ( )g k g k , which contradicts (129).

Suppose now that 1 20 0k k . We have demonstrated that 1 2

1 1k k . We now demonstrate that,

if 10 0x , 1 2

1 1k k . Suppose, to the contrary, that 1 20 0k k and 1

0 0x , but that 1 21 1k k . Since

1 1 1 2 2 20 0 1 1 0 0(1 ) (1 )k x k k k x , (131)

1 20 0k k and 1

0 0x imply that 2 10 0 0x x . We can therefore write the first-order condition for 0

ix

in (31) as an equality,

0 111 21 1

10 20 11 21

( ) ( )( , , ) 1

( , ) ( , )

i ii

k

v c v cp p k

p p p p p p

, 1, 2i . (132)

Since 1 21 1k k , 1 2

1 1c c . Equation (132) therefore implies that

1 20 0( ) ( )v c v c . (133)

Since 1 20 0c c and v is strictly concave, however,

1 20 0( ) ( )v c v c , (134)

a contradiction. ■

Proof of proposition 4: Without loss of generality, assume that 1ˆ 0k . The first-order condition for the consumer’s problem (6) implies that

1

ˆ ˆ1 and = if 0i ir x

. (135)

Therefore, for all 1,...,i n such that ˆ 0ix , 1ˆ ˆir r . Assume that there is a country i for which

ˆ 0ix and 1ˆ ˆir r . Since the rental rate of capital is lower in country i , lemma 1 implies that 1ˆ ˆ 0ik k . Since in a steady state ˆˆ i ix k , ˆ 0ix implies that ˆ 0ik , which is a contradiction.

Consequently, 1ˆ ˆir r for all 1,...,i n . Following the same argument as in the proof of proposition 1, equal rental rates of capital across countries imply equal wages across countries. ■

Proof of proposition 5: Suppose that the economy has a nontrivial steady state with distribution of

capital 1ˆ ˆ( ,..., )nk k . We argue that there exists a nontrivial steady state for all 1( ,..., )nk k that satisfy

1 1

ˆn ni i i i

i iL k L k

(136)

2 1ˆ ˆik , (137)

where ˆj is the capital-labor ratio in industry j , 1, 2j . Each of these steady states has the same

prices and, by construction, the same aggregate capital and production. We need to define the other

42

steady state variables and show that these steady state variables satisfy the equilibrium conditions listed in appendix 1. Let the distribution of capital and labor across industries in each country be

21

1 2

ˆ

ˆ ˆ

ii k

, 2 11i i (138)

ˆi ij j jk . (139)

Since 0ik , we can use the first-order conditions for the investment good (93) to set

21 2ˆ ˆ( / ,1)

ii k

xf x x

(140)

1 1 2 2ˆ ˆ( / )i ix x x x . (141)

We also set ˆ 0ib . It is easy to check that all of the production feasibility conditions (86)–(94) are satisfied in the new steady state. We are left with defining consumption patterns that are consistent with the consumer’s first-order conditions and the feasibility conditions in each goods market. Equation (95) and assumption A.5 imply that 1 2 1 2ˆ ˆ ˆ ˆ/i ic c c c . We use the budget constraint (97) to

define

21 1 2 2

ˆ ˆ( )ˆ ˆ ˆ ˆ/

ii w r k

cp c c p

(142)

1 1 2 2ˆ ˆ( / )i ic c c c . (143)

With these definitions the rest of the conditions that characterize equilibrium, conditions (96)–(98), are satisfied. Condition (101) is satisfied by construction. ■

Proof of proposition 6: There are three steps in the argument. First, we show that, if 1i for

some i then 1i for all i . Second, we show that, if 1i for all i , then i for all i . Third

and finally, we use i for all i to prove that factor prices are equal in the limit.

To prove that 1i for some i implies that 1i for all i , assume, to the contrary and

without loss of generality, that 2 10 1 . Notice that 1 1 implies that there exists 1T such

that 1 11t tc c for all 1 1, 1,...t T T . The strict concavity of utility implies that 1 1

1'( ) '( )t tv c v c for

all 1 1, 1,...t T T . Similarly, there exists 2T such that 2 21t tc c and 2 2

1'( ) '( )t tv c v c for all 2 2, 1,...t T T . Consequently, for all , 1,...t T T , where 1 2max[ , ]T T T ,

2 1

2 11 1

'( ) '( )1

'( ) '( )t t

t t

v c v c

v c v c

. (144)

Notice too that there exists 3T such that 1 1 21t t tk k k for all 3 3, 1,...t T T . Consequently, we

can use the consumers’ first-order conditions (96) to obtain

43

1 2

1 21 2 1 21 11 2

1 1 2 1 1 1 1 1 2 1

( , ) '( ) '( ) ( , )(1 ) (1 )

( , ) '( ) '( ) ( , )t t t t t t

t tt t t t t t

p p p v c v c p p pr r

p p p v c v c p p p

, (145)

which implies that

1 21 1t tr r . (146)

Lemma 1 says that 1 21 1t tk k and 1 2

1 1t tr r is not possible in equilibrium, however, which is the

desired contradiction. To prove that 1i for all i implies that i for all i , assume, to the contrary and

without loss of generality, that 1 2 1 . Consider the function

'( )

( ) lim'( )

ic i

v ch

v c

, 1,...,i n . (147)

The strict concavity of v implies that '( ) 0ih , which implies that 1 2( ) ( )h h . Since

1lim / 1i i it t tc c and 'v is continuous, there exists T such that

1 2

1 21 1

'( ) '( )

'( ) '( )t t

t t

v c v c

v c v c

(148)

for all , 1,...t T T . Consequently, following the same logic as in the argument that 1i for

some i implies that 1i for all i , we can show that 1 2t tk k and 1 2

t tr r , which lemma 1 says is

not possible in equilibrium and which is the desired contradiction. Since i for all i , we know that

1 2

1 1 2 1

( , )lim (1 ) ( )

( , )i t t

t tt t

p p pr h

p p p

, (149)

which implies that

lim it tr r (150)

for all i . The rest of the proof is a modification of the proofs of propositions 4 and 5. ■

Proof of proposition 7: Assume that the model has a cycle of periodicity s . Since ˆ 0itx , the

first-order conditions for the consumer’s problem (6) are satisfied with equality. Multiplying these conditions for 1,..., 1t s and using the fact that 1 1

i ij jsc c , 1, 2j , and 11 1 1sp p , we obtain

1

11(1 ) 1

ss itt

r

. (151)

Assume that there is a period in which rental rates are not equal in two countries, that is, without loss of generality, assume that 1 2

t tr r for some t , 1,...,t s . Equation (151) implies that there

exists 1,..., 1t s such 1 2t tr r . Lemma 1 implies that 1 2

t tk k and 1 2t tk k , which contradicts

proposition 3. ■

44

Proof of proposition 8: Assume, to the contrary, that an equilibrium cycle exists. Proposition 7 says that factor prices are equalized along the equilibrium path. Therefore, since 0i

tx for all i

and t , there exists an equilibrium cycle for the integrated economy. Since the model is one-sector aggregatable, the equilibrium of the integrated economy solves the one-sector social planner’s problem

0max ( )t

ttv c

s.t. ( ,1)t t tc x F k (152)

1 (1 )t t tk k x

0tc , 0tx

0 0k k .

Here, F is the production function

1 2( , ) max ( , )F k f y y

s.t. ( , )j j j jy k , 1, 2j (153)

1 2k k k

1 2

0jk , 0j .

See Bajona and Kehoe (2010) for details. Standard results from, for example, Stokey, Lucas, and Prescott (1989) imply that the aggregate tk is either monotonically increasing or monotonically

decreasing (or constant). Suppose, for example, that 0ˆk k . Then proposition 3 implies that,

since 1

m i it ti

k L k

is strictly increasing, then so are all itk , 1,...,i n , which implies that there are

no cycles. ■ Proof of proposition 9: Assumption A.5' implies that, for given prices, the solution to the consumer’s maximization problem (15) is unique. In a steady state with factor price equalization, each generation in every country faces the same prices and, therefore, chooses the same consumption and saving plans. To see that the steady state is interior to the cone of diversification, observe that, since 0 , there is positive investment in every state and, consequently, assumption A.3 implies that a positive amount of both goods is produced in every country. ■

Proof of proposition 10: Proposition 9 implies that, in a steady state, all countries produce positive amounts of each good, 1, 2j . Assumption A.1 implies that the functions j , 1, 2j ,

that determine the cone of diversification are continuous functions of prices. Therefore, there exists a period T such that for all , 1,...t T T the equilibrium is inside the cone of diversification and factor prices are equalized. Furthermore, all generations born after period t T m face the same prices. The same argument as the one used in proposition 9 ensures that these generations choose the same consumption and saving patterns, making the equilibrium autarkic. ■

Proof of proposition 11: See the proof of theorem 1 in Fisher (1992). ■

45

Appendix 3. Derivations

The first-order conditions for utility maximization and for profit maximization in the

investment sector imply that

2 2 1

2 2 2(1 ) (1 )

i i

i i

ac ax p

a c a x p

. (154)

Feasibility and 1 2 1L L imply that

1 2

2 2 2 2 2 21 2

1 1 1 1 1 1

i i i i

i i i i

c x c x y y

c x c x y y

, (155)

which implies that

1 21 1

1 2 1 21 1 2 2

y ya

y y y y

. (156)

If 1 2 1p p q , we can use the first-order condition for profit maximization into the investment

sector with respect to 1ix to obtain

11 2

1 11 22 2

1a

y yad

y y

, (157)

which implies that

1 21 1

1 2 1 21 1 2 2

11 2 1 2 1 2 1 21 1 1 1 1 1 1 11 2 1 2 1 22 2 1 1 2 2

1y y

ay y y yy y y y y y y y

da y y y y y y

. (158)

By choosing d and a so that 1 2 1p p , we ensure that trade is balanced. To see that this is so,

we add up budget constraints in the steady state of the one-sector model to obtain

2 2

1 1ˆ ˆˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ( )i i ih ih i h i i i i i

h hc x c x w r k w r k

. (159)

We construct the two sectors so that

1 1 2 2ˆˆ ˆ ˆ ˆ ˆ ˆi i i i iw r k p y p y . (160)

46

Since 1 2 1p p , we know that 11 2 1 2ˆ ˆ ˆ ˆ ˆ( ) ( )i i a i a i ic d c c c c and analogously for ˆ ix . Consequently,

1 2 1 2 1 2ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆi i i i i i i ic c x x c x y y . (161)

1 1 1 2 2 2ˆ ˆ ˆ ˆ ˆ ˆ( ) ( ) 0i i i i i iy c x y c x . (162)

47

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Figure 1. Lerner diagram

Figure 2. Revenue function

k

1rk w

1 2 1( / )p p

2 2 1( / )p p

1 1( , ) 1p k

2 2 ( , ) 1p k

51

Figure 3. Steady state and cone of diversification in example 4

Figure 4. Steady state and cone of diversification in example 5

52

Figure 5. Cycle in the pure exchange economy in example 7